Commodity EDGE: The Concepts — Risk Management and Hedging Strategies for Procurement (Dispatch 2)

We're live blogging from Commodity EDGE today and tomorrow. Come on out to the Intercontinental at O'Hare if the topics catch your interest -- it's not too late to attend and we're taking registrations for Day Two, the "Main Event", at the door.

Tom Hronis and Damon Pavlatos of FuturePath Trading kicked off the festivities this afternoon, offering up their views on how procurement organizations can begin to take advantage of commodity risk management programs through hedging category spend. While the first part of their talk was more of a primer on the subject, the second got into the specifics of what options, no pun intended, are available in the market as well as how to get started. Their view, of course, was more tailored to a commodities trading perspective (i.e., we would argue that you still need to get your sourcing and commodity risk management solution and talent infrastructures in place first -- topics we'll address elsewhere in the agenda at Commodity EDGE). But in their view, getting started is relatively simple and involves only a handful of cursory steps. These start with taking your existing organization and analyzed "the product or currencies you need to buy or sell" including "the current price before hedging" to determine if buying or selling with the current price will satisfy your cost or profit objectives.

At this point, you can decide whether or not "if the trend in the marketplace is in your favor (from today to delivery)" to take action with a hedge or to keep your spend "uncovered." Then, it goes without saying that procurement must "track the price of the product until delivery" and to "work with a broker on market research and determine if hedging is right for you" -- either this time or next, or on a permanent "take risk off the table" basis. In fact, to Tom and Damon's argument, we would add that here at Spend Matters and MetalMiner, we're increasingly seeing companies get into hedge not to time market buys and develop a point of view on where markets are headed, but to consistently take risks of the table. For some, it's as simple as this.

One of the benefits (and challenges) associated with hedging using the futures markets -- it should be noted when "call" and "put" options are not used, which we'll get to in a minute -- is that procurement organizations must get their head into a mindset in which not everyone in the market wants to actually take physical delivery of a commodity. Which is why, in part, there is so much potential leverage one can have over a futures contract (i.e., low dollar amounts can theoretically control large volumes of materials/commodities for future delivery). For example, for a 25,000-pound contract for "High Grade Copper" if the current price per pound is $3.87, hedgers, with only a $5K performance bond, can control the entire contract worth $96,750.

However, as Tom and Damon caution, if you're on the wrong side of the agreement and the price falls, you are responsible for any margin calls and new margin requirements generated. And on the other side of the coin, the counter position would be as "the price rises, you also are responsible for any margin calls and new margin requirements generated." In other words, small dollar amounts can control very significant future obligations in the futures markets. But as such, spend can be "locked" with relative ease, provided companies maintain enough margin on reserve to cover the future obligation and the moving price targets in the meantime.

Unlike futures contracts that come with an obligation to take delivery (i.e., you're buying or selling "it" at settlement based on the underlying contract terms), call options provide the "option to buy something by a certain time at a certain price by a certain date" and represent a "a cheaper alternative in lieu of a full blown futures contract" and can also be "used to provide upside protection for short positions." For procurement organizations, a short position could simply be an un-hedged demand.

Stay tuned as Spend Matters covers commodity risk management in significant detail in two forthcoming papers on the topic.

- Jason Busch

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